China’s Great Wall of worry: The top ten causes for concern
The strength of Japanese equities
The below graph reflects the strong performance of Japanese equities over Chinese and Korean equities since the election of Japan’s new Prime Minister, Shinzo Abe, in November last year. Hopes of ending deflation in Japan have led to a strong performance in Japanese markets, while Japan’s neighbors, China and Korea, have seen flat equity markets over the past ten months. Plus, as pointed out in the first part of this series, China’s consumer confidence has seen a significant and ongoing decline, with consumer confidence measures vacillating wildly in a downward trend since the 2008 crisis. This data suggests something has happened in China, as Chinese consumers have never exhibited such wildly fluctuating expectations surrounding their future ability to sustain or grow consumption. This series examines the changes in consumer confidence and overall consumption trends in China and considers the implications for the major Asian equity markets of China, Japan, and Korea.
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The Great Wall of worry: Top ten factors
As we’ve seen in this series and in an earlier series on China’s exports:
- China’s consumer confidence is in a volatile downtrend.
- Consumption as a percentage of GDP is also in a downtrend, and GDP itself exhibits a questionable ability to sustain recovery in historic growth rates post-2008.
- Inflation, as reflected in the Consumer Price Index, remains tame, though soft global growth data could lead to a “return to sender” for China’s exportation of deflation.
- Foreign direct investment (FDI) inflows into China have seen growth rates decline, though absolute volumes of investment at 3% of GDP, or $240 billion per annum, are still quite high. Attention focuses on the sustainability and future direction of China’s FDI.
- Chinese wages in manufacturing have grown rapidly.
- The Chinese yuan, which remains pegged to the US dollar, has appreciated rapidly since 2008.
- As the US Federal Reserve Bank ponders tightening monetary policy, additional upward pressure could develop for the “pegged” Chinese yuan.
- The China Central Bank sent a shockwave through the local financial system in June, leading to a spike in the interbank lending rates from 4% to 11%. This sent a strong signal that the time has come to rein in the rapid rise in debt-financed growth.
- Growth rates in the US and Europe remain soft, casting doubt over future growth rates in Chinese exports.
- China’s gross domestic product, or GDP, growth rates saw a rebound spike post-2008 from 6% to 12%, though they’ve once again headed south to 7.5% as of the second half of 2013. Future GDP growth rates of 7.5% or more are the focus on concern.
Can a bull market in China climb the Great Wall of worry?
As the above graph suggests, China’s and Korea’s equity markets have been fairly flat, while Japan’s equity markets have managed an impressive rally since the election of their new Prime Minister, Shinzo Abe, and the implementation of deflation-slaying monetary and fiscal stimulus. While both China’s and Korea’s equity markets have recovered nicely after the 2008 crisis, Japan has stolen the show in terms of bull market performance over the past year.
Given the trends and considerations mentioned in the above top ten causes for concern for China’s equity markets, the question arises, can Chinese and Korean equities regain the impressive growth trajectories seen in 2003–2008 and again in 2009–2012? Both China and Korea have exhibited strong export growth rates historically, though the rates at which exports are growing in China have declined as its currency continues to appreciate in sync with the US dollar, to which it remains pegged. China’s large foreign currency reserves have served to lower the interest rates in the US in Europe. However, with slack labor markets in these countries, this cheap source of financing consumption could be turning from more of a blessing to a curse. It rests as a monetary anvil on the chest of US and European central banks, which are struggling to reflate their way out of an ongoing financial crisis characterized by a lack of final demand and investment.
Yes, it would appear that China is facing some significant near-term pressures in negotiating the choppy seas of global demand for cheap exports. While low-cost goods are a blessing to economies with declining purchasing power, at some point, they can become an unhealthy addiction, unless the importing country can take advantage of these cheap imports and invest extra cash in future productivity—a trend that has yet to develop in the US.
The Long March begins
In looking to the future, investors will need to focus on signs that the US and European economies can recover, and continue to grow consumption of China’s exports without engendering chronically high rates of unemployment at home. The data series noted above suggests China will have a variety of economic factors to mitigate and optimize in order to return to and sustain its historical growth rates. The new business cycle post-2008 is showing signs of being a very different animal than the easy money growth period prior to 2008. China’s economic data has certainly been choppy the past year or so, and this unease has manifested itself in the performance of China’s equity markets, as the above graph reflects.
The Japanese markets have performed exceedingly well, as the Japanese economy seeks to end deflation and spur economic growth under Abenomics-led reforms. As the Japanese say, “Senri-mo, ippo kara” (The journey of a thousand miles also begins with a first step). In Japan, 2013 has definitely been ushered in with one small step in growth, and with a giant leap in equity returns. In the case of China, it might appear that 2013 could be the first year of a new journey to simply maintain its asset values. Unless global economic growth can pick up its pace, 2013 could be the year for China, in which, once again, “the Long March begins.”
For investors who think China can orchestrate a smooth deceleration in economic growth without significant disruptions to the banking system and also contain inflation, enhance productivity, manage investment growth, and grow domestic consumption, perhaps the weakness in Chinese equity prices over the past two or three years would present a more attractive price. China’s iShares FTSE China 25 Index Fund (FXI) is down roughly 15% from its November 2011 post-2008 highs. For China skeptics seeking to embrace the more recent economic trends seen in Japan and the United States, as reflected in Japan’s Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ), as well as the USA S&P 500 via the State Street Global Advisors S&P 500 SPDR (SPY) and Blackrock’s S&P 500 Index (IVV), the US and Japan markets may appear more attractive than China’s iShares FTSE China 25 Index Fund (FXI) and South Korea’s iShares MSCI South Korea Capped Index Fund (EWY). For further analysis as to why Chinese equities could continue to underperform Japanese equities, see Why Japanese ETFs outperform Chinese and Korean ETFs on “Abenomics.”